Editor’s note: This article was first published in April 2014. It describes OTC Markets’ tiers and disclosure rules as of 2014; the tier structure and requirements have changed since.
At the request of many of our readers, we’re going to explain in depth what penny stocks are and how to tell whether one of the companies quoted on OTC Markets is reliable or, on the contrary, of dubious credibility. We’ll also bust some myths about these stocks and shed some light on this high-risk investment.
It’s true that every big company starts out as a small company. Even Apple and Google, before becoming one of the most valuable companies on the planet, had just a couple of employees in their day. Every investor dreams of spotting a company that’s just starting out, buying its shares at $0.10 and seeing them trade at $600 a share ten years later.
We recently published the story of the trader who turned $1,500 into $1 million by speculating in this market. There are even stories of investors who held shares at $0.003 that, after a takeover by a large company, shot up to $3 in a single morning, making that investor a millionaire overnight.
Of course, going into OTC Markets hoping to find the next Apple is, to say the least, a risky and unlikely investment strategy.
1. What exactly are penny stocks?
To start with, we need to distinguish the concept of “penny stocks” from what Spanish investors call chicharros (highly speculative, thinly traded stocks) and from small-cap companies. For the Securities and Exchange Commission (SEC), a small-cap company is any company with a market capitalization of between 50 and 300 million dollars.
Although the term “penny stock” is applied to any company trading below 1 dollar, the high risk of penny stocks comes not so much from their price as from their origin and situation. Any company trading below 1 dollar or 1 euro will always carry more risk, and probably more volatility, than the rest, but it isn’t necessarily a penny stock. The penny stocks used to swindle investors come from OTC Markets, and we’re going to see why they carry such high risk.
2. Types of penny stocks
On OTC Markets there are three tiers of penny stocks, which, as with bonds, are classified according to the company’s risk. These three tiers are OTCQX, OTCQB and OTC Pink. We’ll start with the riskiest.
A. OTC Pink
Of the three tiers, OTC Pink (the “pink sheets”) are the lowest quality. They include companies in default or with serious liquidity and financing problems, as well as a large group of companies that don’t yet have a single product on the market. In other words, some of them have no business at all and are just a project or a laboratory study. They are companies that don’t meet the requirements to be listed and aren’t required to file reports with the SEC, so all the information investors receive is what the company itself publishes. These companies aren’t audited, so you could be sold shares in a company that hasn’t had any commercial activity for more than 12 months.
B. OTCQB
These sit in the middle tier of risk. Like OTC Pink companies, they don’t meet the minimum financial standards to be listed on a decent exchange. But unlike OTC Pink, these companies are required to file the relevant documents and accounts with the SEC. Even so, this is still where you’ll find very small or early-stage companies, and no investor knows for sure whether they will become profitable at some point or end up disappearing.
C. OTCQX
These companies enjoy more credibility, within the risk they still carry. At this tier you find companies that meet many of the financial standards and that are, in a way, sponsored by other companies or big investors betting on the company’s future. Investors do have access to transparent, audited accounts for these companies.
JP Morgan and Deutsche Bank often “sponsor” many of these companies, acting as mentors and backing them, which doesn’t stop many of them from failing to take off. Still, the probability of success when investing in one of these companies, while low, is much higher than with the two previous options. At this link you can see which companies trade at this tier and who sponsors them.
3. Why these penny stock companies are so risky
First of all, the biggest danger of investing in one of these companies is the lack of information about the company in question: even if we see a name like “Energy Corporation”, the company could be operating out of the bathroom of an abandoned house. Since OTC Pink companies aren’t required to file statements with the SEC, they tend to be fraudsters’ favorites.
These companies also pay media outlets to publish their own news, for example: “Energy Corporation increases profits by 150% in the first quarter”. Nobody can know whether it’s true, and sometimes they boast about strong performance because they’ve gone from turning over €3,000 to €7,000 a year, which is an increase of more than 100% but hardly something to write home about.
The company’s origin is an added risk too. While some of these companies are too new (they have no track record), others have been kicked out of the indexes because of their high risk and sent to this market to slowly die.
4. The high risk of trading penny stocks
These companies don’t have much liquidity, so investing just €100 can push the share price up 700%. A buy order is almost always welcome. The problem is that sell orders can become a real headache unless we’re willing to sell far below the quoted price.
5. How are penny stock prices manipulated?
Taking advantage of the lack of information and low liquidity, many firms specialize in buying large blocks of shares in these companies at rock-bottom prices and then sending indiscriminate emails to a large database of retail investors, as well as phoning investors to tell them they have inside information and that the company is about to soar in the short term.
What they do is sell those shares for 300% or 500% more, carrying out a “pump and dump” strategy, which is completely legal, since all you’ve really done is sell something you own to a buyer who was willing to pay the price you asked. The problem is that the buyer won’t be able to sell their shares because there are no buyers, unless they sell them 50% or 75% cheaper.
So when you come across a very positive story about a penny stock in a financial newsletter, there’s a high probability that the story was paid for by the company itself or by a brokerage that holds shares in it.
6. False beliefs about penny stocks
Many investors are drawn to these stocks trading at $0.0003 because they think they have much more room to rise. Bear in mind that with 600 dollars we could buy 2 million shares, so if the company ever reached just $0.10, we’d make 200,000 dollars. We’re not saying this has never happened, but for every person who has become a millionaire on OTC Markets, there are 1,000 investors who have lost their shirts buying these stocks.
The other false belief, one I fell for myself, was thinking that companies like Apple and Microsoft had been penny stocks in their early days. It’s an argument fraudsters use to sell you these stocks, because although the price history shows these companies trading at $0.09, the truth is that they went public at much higher prices.
7. But penny stock investing has a positive side too
Although these investments aren’t suitable for every investor, since they carry a high risk of losing all our money, if we analyze a company, understand its sector and see something coherent in it, we could spot a great investment opportunity.
It’s said that many companies are working on very interesting solar energy projects, and that the technology needed to get the most out of renewable energy might even be sitting in one of these penny stock companies right now. The problem is that there are so many of them that it would be hard to pick which one has the best chance of being bought by a giant or of becoming profitable on its own.
And that’s basically what you need to know about penny stocks. It’s a market where the risk is so high that if things went your way you could literally become rich, but you should always go in knowing that you’ll most likely lose practically your entire investment, especially if you choose the first two options (Pink and QB).
Further reading
Featured image: cweyant from Syracuse, United States, CC0 1.0, via Wikimedia Commons.
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